[Options ABC] Earnings season essentials: Implied Volatility, a must-learn for option traders

Hello everyone and welcome back to moomoo. I'm options explorer. In today's [Options ABC], we'll be taking a look at a vital concept of options trading: Implied Volatility.

But before we dive into that, let me hit you with a little brain teaser:
If you're looking to speculate on market volatility during earnings season, you could go for:

Volatility measures the uncertainty of returns from financial assets, usually calculated as the standard deviation of returns over a certain period. To be more specific, it reflects the frequency and magnitude of price movements. In options trading, Implied Volatility (IV) and Historical Volatility (HV) are common measures of volatility. While HV is based on past data, IV looks ahead and reflects the market's expectation for future price swings. In this article, we'll focus on IV.

Let's say Alice thinks that the stock XYZ will swing wildly during its upcoming earnings announcement. She's more likely to buy options because whether she buys a call (thinking it will go up) or a put (thinking it will go down), a bigger swing means a higher opportunity of profit. As more investors lean towards buying options, the demand and thus the price of these options will increase, pushing up IV.

Let's assume Joe sees that XYZ's stock has dropped 9% after its earnings release and thinks it'll stabilize for a while, meaning less volatility. In this case, he might sell options, either calls or puts, because less volatility could mean the intrinsic value of the options won't change much. As expiration approaches, the time value of the option decreases, which is good for the seller. As more investors sell options, supply goes up, potentially pushing down the premium and reducing IV.

The primary characteristic of Implied Volatility is its mean-reverting nature. This means that implied volatility tends to move back towards its average over time, even after significant fluctuations. When IV rises too high, it's likely to drop back, and vice versa. Given IV's importance, how can we use it to make more informed investment decisions?

Before discussing strategies related to IV, let's take a look at the concept of Vega. Vega measures how sensitive an option's price is to changes in the asset's volatility. You might have heard terms like "going long on volatility" or "going short on volatility." These relate to whether Vega is positive (long) or negative (short).

Ignoring other influencing factors, if you go long on volatility and the stock's implied volatility actually rises, you could be in for a profit. But if it falls, you'll likely face a loss.
To help you better understand, I'll list some common strategies with their Vega and IV characteristics.

Advanced traders who specialize in volatility often create multi-leg strategies using different options contracts to potentially take advantage of opportunities. They may use tools such as the Volatility Term Structure and Volatility Smile to analyze these potential opportunities. These tools are available under the Options Analysis tab on moomoo.

The volatility term structure shows the relationship between implied volatility (IV) for options of the same asset but with different expiration dates. Generally, there are two types: upward-sloping and downward-sloping.

An upward-sloping volatility term structure means that as the expiration date gets further away, the IV tends to increase. This suggests the market expects the asset’s volatility to rise over time. In this scenario, traders might buy short-term options (which are cheaper due to lower time value) and sell long-term options (which are pricier). This strategy can capitalize on the faster decline in value of short-term options.

A downward-sloping volatility term structure indicates that IV decreases with longer expiration dates. This suggests the market expects lower volatility in the future. Here, traders might buy long-term options (cheaper due to higher time value) and sell short-term options. This strategy leverages the rapid time value decay of short-term options and the higher time value of long-term options in an attempt to profit.

The volatility smile is a curve that shows the relationship between an option's implied volatility and its strike price. Typically, this curve forms a U-shape, often attributed to varying market demands and perceptions for options at different strike prices.

Of course, all of the cases we've discussed are just ideas to share, and should not be taken as investment advice. Remember, you're solely responsible for your own trading profits and losses.

That wraps up this session of Options ABC. If any of you have different ideas or thoughts, feel free to share and discuss them in the comments section.